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A Cross-sectional Asset Pricing Test with More Power: An Instrumental Variable Approach

In: Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives In 4 Volumes

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  • Jungshik Hur

Abstract

I find that downward bias of the estimated coefficient of betas in the Fama-MacBeth cross-sectional regression is caused by endogeneity of the estimated betas due to measurement errors. I propose an instrumental variable methodology that purges the endogeneity. The purged betas have a 95% correlation with the original betas and retain the relation with firm size. I document that controlling for the purged betas in the Fama-MacBeth cross-sectional regression has higher statistical power to correctly reject the null hypothesis of nonexistence of size premium and also has higher R-squared and higher total sum of squares than the Brennan-Chordia-Subrahmanyam (1998) methodology.

Suggested Citation

  • Jungshik Hur, 2024. "A Cross-sectional Asset Pricing Test with More Power: An Instrumental Variable Approach," World Scientific Book Chapters, in: Cheng Few Lee & Alice C Lee & John C Lee (ed.), Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives In 4 Volumes, chapter 108, pages 3547-3581, World Scientific Publishing Co. Pte. Ltd..
    • Handle: RePEc:wsi:wschap:9789811269943_0108
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    Keywords

    Financial Accounting; Financial Auditing; Mutual Funds; Hedge Funds; Asset Pricing; Options; Portfolio Analysis; Risk Management; Investment Analysis; Momentum Analysis; Behavior Analysis; Futures; Index Futures; CDCs; Financial Econometrics; Statistics; Financial Derivatives; Financial Accounting;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G1 - Financial Economics - - General Financial Markets
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • M42 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Auditing
    • G3 - Financial Economics - - Corporate Finance and Governance

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